Fed moves to head off risky investments by banks

CRAIG TORRES and SCOTT LANMAN, Bloomberg News

Published 5:00 am, Friday, October 23, 2009

The Federal Reserve on Thursday proposed new guidelines on pay practices at banks and said it will launch a review of the 28 largest firms to ensure compensation packages don't create incentives for the kinds of risky investments blamed for the financial crisis.

“Compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability,” Fed Chairman Ben Bernanke said in a statement. “The Federal Reserve is working to ensure that compensation packages appropriately tie rewards to longer-term performance.”

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The central bank's action parallels efforts by U.S. lawmakers, the administration of President Barack Obama and world leaders to overhaul incentives usually set by corporate boards and reduce threats to the financial system. Investments in mortgage-backed securities and other complex instruments have led to more than $1.6 trillion in credit losses and write-downs, triggering the worst economic crisis since the 1930s.

The central bank said it will conduct reviews comparing compensation practices of the 28 banks, which it didn't name.

The largest banks will have to describe plans to align pay practices with the Fed's proposed guidelines. The central bank may take enforcement action against banks where compensation or risk-management practices threaten “the safety and soundness” and no prompt measures are taken to address them.

Banks could make compensation more sensitive to risk, the Fed said in its proposed guidelines, by “significantly” delaying the payout of a bonus. They could also extend from one year to two the period covered by performance measures, and adjust bonus payments for any actual losses that become clear during the deferral period, also called a “clawback.”

Compensation practices at the thousands of smaller banks will be reviewed in the normal course of their risk management examinations, the Fed said. In 2008, the Fed supervised 5,757 U.S. bank holding companies as well as 862 state-chartered banks.

The Fed plan comes as the Obama administration slammed Wall Street by ordering pay cuts and caps on benefits for top executives at companies owing the government billions of dollars from taxpayer-funded bailouts.

The news triggered debate about the government's reach into private industry, whether pay reductions would spread to other companies and if a talent drain from U.S. firms would ensue.

“There is entirely too much reliance on cash, and there's got to be a better way to tie corporate performance to long-term growth,” said Kenneth Feinberg, the Obama administration's special master for executive compensation. Executives at seven companies including Citigroup and Bank of America Corp. will have their pay cut by an average of 50 percent after months of negotiations with Feinberg.

The Fed acted to increase its scrutiny of pay practices after it came under fire from lawmakers for lax oversight of banks and housing before the financial crisis.

Bank of America complained that the pay restrictions would hurt its ability to retain top employees. Citigroup said it was pleased the decision had been issued.

Obama welcomed the government decisions and said Americans' values are offended by excessive paychecks for executives whose companies were bailed out by taxpayers. He urged Congress to pass legislation to give shareholders a voice in executive pay packages.